Get Ready for the Next Leg Up in Oil

Sean Brodrick | Wednesday, July 30, 2008 at 7:30 am

Oil has pulled back from its highs, and now analysts are lining up to say the top is in. I’ve been saying all along that volatility is the name of the game in oil this year. Let me tell you now that I think oil could go lower in the short term — maybe to $110 a barrel, $100 if we’re really lucky. Then, hold on to your socks, because we’re probably seeing the set-up for oil’s next HUGE rally.

Why do I think crude oil may have some more work to do on the downside? Nothing goes up in a straight line, and crude’s run has been phenomenal — it was trading at just $78 a barrel a year ago. A short-term pullback is a normal and necessary part of any bull market, and crude is no different.

Short-term drivers that could push crude oil to $120 or even $110 a barrel include …

Easing tensions with Iran.

U.S. consumers driving less — 3.7% less than this time last year, according to the Department of Energy. That doesn’t sound like a lot, but it’s a savings of 9.6 billion miles and hundreds of millions of gallons of gasoline.

Expectations that Chinese demand will slack off now that preparations for the Olympics are finished.

Fears that the financial crisis will translate into more pain for the U.S. economy and consumers.

Still, these are all short-term forces. For example, people are driving less because prices at the pump went up so far, so fast, that it came as a shock. Let prices go down a bit, let people get used to new “higher lows,” and we’ll probably see demand pick up again.

Now, let me tell you about some of the LONG-TERM forces in play that should drive oil to $150, $200 a barrel and beyond …

Thirsty Tigers: The U.S. may be the world’s leader in energy thirst (over 20 million barrels of oil a day) but China is coming on strong. According to the Energy Information Administration (EIA), China consumed 7.6 million barrels of petroleum each day of 2007. That’s up 860,000 barrels/day in just two years.

What’s more, Rigzone.com reports that China’s oil imports in the first half of 2008 imply an increase of 480,000 barrels a day over the same period a year earlier.

Drive Me Crazy: What is China doing with all that oil? Fueling cars. In China, car sales rose by 20% in the first quarter of this year to 1.85 million vehicles. And while SUV sales are tanking in the U.S., the number of SUVs sold in China rose 43% in May compared with the previous year. Indeed, China’s demand for gas is much of the reason for the run-up in global oil prices.

China alone accounts for about 40% of the world’s recent increase in demand for oil. Fifteen years ago, there were almost no private cars in the country. China now has 15.2 million private cars. Still, less than 4% of the country’s 1.3 billion people have already bought a car. That’s the same percentage of car ownership the U.S. had in 1915!

China, India, and other emerging markets will continue snapping up cars — and oil — like crazy.

Emerging Markets in the Driver’s Seat: China isn’t alone. Demand is also soaring in India (up about 7% year over year), where the locals are lining up to buy the world’s cheapest car, the $2,500 Tata Nano. India’s government will spend $42.5 billion this year on oil subsidies — twice what it spent last year. And that’s AFTER subsidies were scaled back in June.

And oil demand is also booming in Russia, across Asia, and the Middle East. In 2008 China, India, Russia and the Middle East for the first time will consume more crude oil than the U.S., burning 20.67 million barrels a day, an increase of 4.4% over year earlier levels, according to the IEA. U.S. demand will contract 2% to 20.38 million barrels daily.

Won’t Less Demand from Developed CountriesOffset This Emerging Market Thirst?

No. Even though the U.S. Europe and Japan saw their combined demand drop by 760,000 barrels a day, according to the EIA, that’s not enough.

China Syndrome:Oil demand is rip-roaring, and will overtake the U.S.

If China’s present growth rate of oil demand continues at its current pace (6% to 7% per year) China will use 20 million barrels a day by 2020. That’s about as much as the U.S. uses today.

And by 2030, China would be up to 40 million barrels a day — TWICE what America is using now.

Meanwhile, Supplies Are Strictly Limited!

EIA data shows the amount of petroleum products shipped by the world’s top oil exporters — 15 countries which account for 45% of all production — fell 2.5% in 2007, despite a 57% increase in prices. This trend is continuing this year, as petroleum exporters use more and more of their own oil.

For example, last year, the region’s six largest petroleum exporters — Saudi Arabia, United Arab Emirates, Iran, Kuwait, Iraq and Qatar — curbed their shipments by 544,000 barrels a day. At the same time, their domestic demand increased by 318,000 barrels a day, leading to a loss in net exports of 862,000 barrels a day.

Well, we’ll just get oil from outside of OPEC, right? Sorry, but the International Energy Agency says that production in non-OPEC countries is set to peak within the next two years. Fatih Birol, chief economist of the IEA, pointed a finger especially at the North Sea, where production is falling at 7.5% per year, and at Mexico, which is experiencing double-digit percentage declines in oil production.

All this is squeezing global spare capacity mercilessly. The global supply cushion is officially listed as 2 million barrels a day; in reality it’s probably less. It wouldn’t take much of an emergency to take away all that spare capacity and then some.

Indeed, we saw crude firm on Monday on news of more attacks on pipelines in Nigeria and the news that the United Arab Emirates will cut its production by at least 100,000 barrels per day for up to 40 days starting in October. You have to wonder what’s going to happen next.

Then there’s …

Mexico: Been Down So Long, Don’t Know Which Way Is Up

Petroleos Mexicanos, the state-owned energy company, said Mexico’s oil output fell 11% in June from a year earlier. The decline at its flagship Cantarell field is even worse — down 35% year over year!

Mexico is pumping new fields to compensate for the drop at Cantarell, but can’t bring on enough oil quickly enough.

Remember, Mexico is the third-largest supplier of crude to the U.S. It exported 1.415 million barrels in June, down 19% from the previous year, and the lowest level in a dozen years. This is already affecting a name you’re probably familiar with — refiner Valero Energy. Mexico told Valero it would cut supplies to one of the company’s Gulf Coast refineries by up to 15%.

What About the Good ‘Ol U.S. of A?

Four decades ago, the U.S. was the biggest oil producer in the world. But America’s crude oil output peaked in 1970, at 9.6 million barrels a day, which was enough to cover most of the country’s needs back then.

Now, U.S. crude production stands at 5.1 million barrels a day. On the demand side, America consumes one of every four gallons of oil in the world but has barely 3% of the world’s proven reserves of conventional oil.

End result: The United States now imports nearly 60% of its crude, twice the ratio of imports before the 1973—74 Arab oil embargo, as we thirst for the fuel to drive 220 million cars.

Our demand is going down for now. But the real drivers of global demand are in the emerging markets. So even if we cut back on our oil usage, oil prices will probably continue to zig-zag inexorably higher.

In the short term, the only answer is conservation. “Drill, Drill, Drill” isn’t realistic because all the oil rigs are rented out for the next three to five years. Heck, we may have even less — the contracts for sea-based rigs are being snapped up by national oil companies from Brazil to Saudi Arabia, and Chinese oil companies make shopping trips for land-based rigs in North America. They break ’em down and ship ’em back home for their own urgent energy exploration program.

Longer-term, as I told you last week, I think we’ll use a regular “energy buffet” of wind, solar, nuclear and more.

But Peak Oil is coming — or already here — and as the world’s remaining giant oil fields follow Mexico’s Cantarell into decline, you will be amazed by just how high oil prices can go.

So Take Steps to Protect Yourself and Profit!

There are two great energy funds that have gotten cheaper as oil has pulled back. I don’t think they will be down for long.

The United States Oil Fund ETF (USO) tracks the price of oil pretty closely by holding crude futures contracts. I consider it a good place to be to ride the next leg up in oil.

I also like the iShares Dow Jones US Oil & Gas Exploration & Production Index Fund (IEO), which is stuffed with good stocks including Occidental Petroleum, Devon Energy, Apache Corp, EOG Resources and more. Those are the kind of stocks that will make the most of the big oil bull market. After all, these stocks make money hand over fist when oil is at $100 a barrel — they’ll make an absolute killing when oil goes to $150 … $175 and higher.

Money and Markets (MaM) is published by Weiss Research, Inc. and written by Martin D. Weiss along with Tony Sagami, Nilus Mattive, Sean Brodrick, Larry Edelson, Michael Larson and Jack Crooks. To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MaM, nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MaM are based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates but must be considered hypothetical in as much as we do not track the actual prices investors pay or receive. Regular contributors and staff include Kristen Adams, Andrea Baumwald, John Burke, Amber Dakar, Dinesh Kalera, Christina Kern, Red Morgan, Maryellen Murphy, Jennifer Newman-Amos, Adam Shafer, Julie Trudeau and Leslie Underwood.

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